A possible end of the financial world (as we know it)

Probably you’ve followed what happened on financial markets last week. To better understand, it is useful to remember the story of “Long Term Capital Management” (LTCM) hedge fund.

Hedge funds are investments funds that undertake a wider range of activities than other investment funds: activities that other funds can’t undertake since they are too risky. For example, their regulation allow them to short sell, which is usually avoided by “standard” funds, to increase risk in order to maximize returns. For these reason these “speculative” funds are usually opened to a limited range of investors, that must meet strong requirements: an accredited investor needs to have a minimum net worth of $1,000,000 or, alternatively, a minimum income of $200,000.

Although they follow risky strategies, hedge fund on average can reach positive results, since they are the “strong hands” in the market, and can influence markets: in 2006, hedge funds managed something like 1.900 billion dollars, a sum higher than Italian GNP (that in 2006 was 1.850 billion dollars).

Long-Term Capital Management (LTCM) was founded in 1994 by John Meriwether and in the board there were Myron Scholes and Robert C. Merton, who received Nobel prize for economy in 1997. The fund based its strategy on complex mathematical techniques, to exploit earning opportunities. And in fact, in the first years LTCM got annualized returns of over 40%. This also thanks to an high leverage: in 1998, LTCM had capital for $4,72 billion, and had loans for $125 billions — a leverage ratio near to 27.

In 1998, there were some events not expected by mathematical models (most notably, Asia and Russia crisis): this didn’t damage that much the fund, but incomes were definitely lower than previous years. But this led many investor to exit from LTCM, reducing its capital: but the fund couldn’t disinvest fast as much, and the fund ended at some point to operate with a leverage ratio near 55. A leverage that high it may be nice when things go fine, but if they turn bad, it may be a real nightmare. Just think that, with such a leverage, if you buy a security and its price rise 2%, you more than double your capital, but if it falls 2%, you lose more than your capital. And this is what in the end happened to LTCM, because — to cite Keynes — it may be true that markets tend to a rational and mathematically predictable position, but “markets can stay irrational more than one can stay solvible“.

To avoid a chain reaction that could have lead to a wide market collapse, FED had to intervene, organizing a bailout of the hedge fund by the major creditors.

Many feared that last week could happen something similar, and maybe to more than one hedge fund, which could complicate things. This risk isn’t over, since bottom problems (first of all, system transparency) are still there.

Moreover, there is a additional risk element from the fact many banks and investment funds by regulation have to use stop-loss rules, i.e. when the loss overcome a certain amount, they may have to sell the asset. But, since the amount of securities owned is relevant, a massive sell can exacerbate the price slide, possibly starting a chain reaction. Luckily, this time everything has ended well. Let’s hope next time it will be the same.